FHA Faces Extreme Capital Shortfall; Risks Treasury Bailout

fha-logoFederal housing policy, understandably, these last several years has focused on preventing mortgage foreclosures, not just on initiating them. Yet the Federal Housing Administration (FHA), despite efforts to stem the tide by the Obama administration, has grown into a fiscal black hole in the wake of the 2007-08 mortgage industry collapse and the subsequent tightening of credit standards for conventional loans. FHA-insured loans, according to a recent study, account for 30 percent of purchases of new homes and close to 20 percent of purchases of existing homes, far above historical norms. Many are at risk of foreclosure. An FHA “short sale” program designed to enable borrowers to avoid foreclosure has experienced substantial fraud. FHA, severely undercapitalized, faces a Treasury Department bailout that already may have begun.

Let’s put the issue in context. The housing market over the last several months has shown real improvement. In fact, it is now in better shape than in a half-decade, nationally and especially in certain hard-hit local markets such as Las Vegas and Phoenix. New housing starts nationwide have increased to an annualized rate in the 700,000-to-800,000 range – well below the 1.3 million average of 1992-2007 yet well above the roughly 500,000 a year for 2008-11. Publicly-traded homebuilders Lennar Corp. and KB Home last month reported sharp increases in quarterly earnings. The Standard & Poor’s/Case-Shiller Index, which tracks home prices in 20 major metropolitan areas through a “repeat sales” methodology, registered a 5.9 percent increase for this year through July. That’s significantly higher than the respective January-July gains of 2.0 percent and 0.4 percent in 2010 and 2011. And it’s a major turnaround from the respective losses of 2.3 percent, 10.1 percent and 4.1 percent through the first seven months of 2007, 2008 and 2009. Meanwhile, buying opportunities abound given the decline in overall interest rates on 30-year, fixed-rate mortgages to less than 3.4 percent, the lowest level in more than 50 years.

Yet this rebound could reverse itself rather quickly, given the large numbers of borrowers who have lost and are continuing to lose their homes, not to mention those seriously delinquent. Foreclosure levels likely will increase over the next few years now that banks are getting a handle on the backlog of foreclosures that accumulated during the multi-state probe into the hasty processing, or ‘robo-signing,’ of foreclosure papers, which five major banks settled for $25 billion in February. Even many borrowers current in their payments have negative equity in their properties; that is, the outstanding principal exceeds the current market value, a condition popularly referred to as “underwater.” Mortgage Bankers Association data show that by the close of the First Quarter 2012, 11.8 percent of outstanding residential mortgage loans were in distress. About 7.4 percent of those loans were 30, 60 or 90 days past due, and the other 4.4 percent were in foreclosure. The proportion of “underwater” homes, despite the surge in property values, remains high. According to the Santa Ana, Calif.-based real estate tracking firm CoreLogic, 23.7 percent of all residential properties in the U.S. with a mortgage had negative equity during the First Quarter of this year, only slightly down from 24.7 percent in First Quarter 2011 and 25.2 percent in Fourth Quarter 2011. On top of this, banks have become unusually strict in their standards for approving mortgage applications, in the process frustrating many reasonably creditworthy house seekers. Their newfound stringency in part has been driven by demands by secondary mortgage lending giants Fannie Mae and Freddie Mac, each a effectively ward of the U.S. Treasury Department since September 2008, that they repurchase more than $65 billion in mostly defaulted mortgages sold (by the banks) during 2006-08.

Such realities take on an extra urgency when viewed in the context of FHA’s recent lending patterns. Since its creation by Congress in 1934 under the National Housing Act, the Federal Housing Administration has been in the business of mortgage insurance. It exists not to make loans, but to insure them against the risk of default. To support its operations, FHA charges lenders risk-adjusted premiums; the lenders, in turn, pass the cost onto borrowers. Should a borrower be unable to pay back the mortgage, the agency reimburses the lender for all outstanding principal. This arrangement, remember, came about during the depths of the Depression, with the housing industry at a virtual standstill. Lenders needed some measure of confidence they could collect what they loaned out. Private mortgage insurers (PMIs) were going bust. And federal, state and local treasuries were stretched to the limit, if not broke.

In addition to financing operations through premiums, the Federal Housing Administration introduced major innovations that we have come to take for granted. First, FHA loans required small down payments, certainly far smaller than had been the case prior to the Depression. The current figure is 3.5 percent (up from 3.0 percent prior to 2009) for most borrowers. Put another way, the standard loan-to-value (LTV) ratio is now 96.5 percent. Before FHA, they generally were about 50 to 60 percent. Second, these mortgages were long-term, typically written for 30 years. Prior to the advent of FHA, lenders usually wrote mortgage loans for three to five years. Third, FHA introduced the self-amortizing mortgage, by which each payment builds up equity (i.e., reduces principal) in progressively larger amounts. Until then, mortgage payments typically lacked this feature, effectively functioning as interest-only mortgages. At the expiration of the term, the borrower would have to pay the principal in a lump sum payment or lose the property.

FHA laid the groundwork for America to become a majority-homeowner nation. At the end of World War II, the percentage of dwellings that were owner-occupied stood at between 40 and 50 percent. Aided by the adoption of FHA standards, the figure would climb to over 50 percent and eventually to over 60 percent. By participating in FHA programs, and more importantly, by applying FHA practices to conventional lending, lenders enabled tens of millions of young adults to buy, remodel or refinance homes without putting severe strains on their monthly expenses.

Yet FHA was never meant to supplant conventional lending. And by the 1960s, with the housing industry going at full steam, and with private mortgage insurers resurgent, the agency arguably had outlived its usefulness. It was not a prevalent view. The agency remained remained popular in both major parties, not to mention the homebuilding, lending and real estate sales industries. The creation of HUD by Congress in 1965 the wake of massive black rioting in Los Angeles’ Watts area made the prospect of repeal all the more remote. The new cabinet-level department assumed control over FHA, and just a few years later, was pressured by Congress to promote homeownership for low- and moderate-income households.

The Federal Housing Administration has several insurance funds, each corresponding to a particular type of housing. By far the largest and most important is the Mutual Mortgage Insurance Fund (MMI Fund or MMIF), which covers single-family dwellings. It is true that the MMIF never has required a congressional appropriation (i.e., bailout) in its entire history. But it has had a few close calls, especially during the real estate slump/savings & loan collapse of late Eighties. An outside audit by Price Waterhouse had concluded the fund would not survive in absence of restructuring. This report spurred FHA reforms included in the National Affordable Housing Act of 1990 (Cranston-Gonzalez Act). Under the law, if capitalization (i.e., cash or other liquid assets on hand) falls short of a required minimum, FHA must cover the difference by raising allowable premiums or the minimum capital standard, the latter at present being 2 percent; the PMI industry minimum is currently 4 percent.

Yet it may take even stronger measures to render FHA actuarially sound. True, a capital shortfall doesn’t mean the agency has to come up that sum all at once. FHA liabilities represent an estimate of long-term payouts relative to projected revenues. But a study released last November by the American Enterprise Institute concluded that FHA’s income stream isn’t sufficient to stave off insolvency. The author, Joseph Gyourko, a professor of real estate finance at the University of Pennsylvania’s Wharton School, argues that FHA, by supplanting a large portion of conventional lending in the wake of the mortgage industry collapse of 2007-08, has left itself dangerously exposed. He concluded:

…There is no doubt the MMIF is materially underreserved by at least $50 billion, with the true figure likely higher. Depending on how much one wanted to be above the 2 percent ratio guideline, between $50 billion and $100 billion likely is needed to recapitalize the MMIF in a safe manner. That range is based solely on correcting errors in estimation strategy and techniques, as well as data organization. If the economy and housing markets deteriorate unexpectedly, we need to be ready to infuse even more capital into the MMIF.

While a sudden liquidity crisis of the sort we experienced in 2008 isn’t likely, Gyourko maintained, that hardly should be a source of comfort. “Large losses are to be expected on any entity in the business of insuring thirty-to-one leveraged investments (in housing or any other asset market),” he wrote. “Such investments are very risky in the best of economic environments and become markedly more so in weak ones.” Just to meet statutory capital reserve requirements, FHA would have needed an infusion in fiscal year 2010 of more than $12 billion.

So how did FHA dig itself into this hole? In essence, it has become the insurer of the first resort rather than of the last resort. Aggregate insurance in force since fiscal year 2007 – i.e., just prior to the Great Financial Meltdown – has more than tripled from $305 billion to over $1 trillion. This is reflected in data for FHA loan volumes relative to all mortgages. During fiscal years 2000-07, FHA-insured loans accounted for anywhere between 5 percent and 10 percent of all new home purchases. Yet the figures for 2008, 2009 and 2010, respectively, were 17.6 percent, 26.6 percent and 30.0 percent. For existing home purchases, the FHA share, after declining from 15.0 percent to 3.8 percent during 2000-07, rose to a respective 11.9 percent, 18.0 percent and 18.3 percent during the three years after that.

Making this all the more problematic have been declines in property values. House price appreciation and net equity, whether measured by the Federal Housing Finance Agency (FHFA) or the S&P/Case-Shiller price indices, dropped during 2005-11. More than half of all FHA insurance in force, in fact, is liable for mortgages with negative equity. An analyst for Standard & Poor’s, Eric Ojo, noted two years ago: “The income ratios might be a little tighter and more income verification required than in 2006, but the FHA is indirectly becoming a subprime lender through its guarantees of low down payment mortgages.”

The balance sheets, if anything, have gotten more ominous. By the close of July of this year, 16.52 percent of active FHA loans were delinquent (late by at least 30 days). Of those loans, nearly 60 percent were “seriously delinquent” (late by at least 90 days) or are in some stage of foreclosure. Payouts to lenders, which can include the cost of insurance itself and any seller premiums, also are high. In Third Quarter 2012, the MMI Fund paid $5.3 billion in claims. By the close of July, FHA had a net worth of minus $24.44 billion. Based on Generally Accepted Accounting Principles (GAAP), this constitutes a decline of $7 billion since the end of fiscal year 2011 alone. Over the long term, estimated liabilities now exceed assets by anywhere from $44 billion to $63 billion. And last November, in its annual financial status report to Congress, HUD noted that the MMI Fund capital ratio was 0.24 percent, which was not only well under the statutory 2 percent standard, but below the 0.50 level of a year earlier as well.

How will FHA cover these shortfalls? The answer: In all likelihood, it won’t. The agency recently projected it will wind up fiscal 2012 with $3 billion in reserves, far lower than the $11.5 billion it projected in its fiscal year 2011 actuarial report. Raising insurance premiums and minimum capital requirements only will go so far. A congressional appropriation appears inevitable. Indeed, argues Dan Murphy, general counsel of the Washington, D.C.-based consulting firm BGR Group and HUD’s chief of staff during 2001-02, it’s already happened. Writing several days ago in National Review Online, he noted:

Tucked away in President Obama’s 2012 budget proposal was a little-noticed provision telling Congress that it may need to provide $688 million to cover the FHA’s projected losses this fiscal year. Translation: The FHA will need a bailout for the first time in its 75-year history. Since that proposal came out, the Department of Housing and Urban Development (HUD), which oversees the FHA, has announced a hasty $1 billion settlement with Bank of American for alleged mortgage-market violations. This provided HUD with a Band-Aid to cover the FHA shortfall through October 2012. But the problem has not been solved, merely postponed. Below the radar, FHA is still hemorrhaging money from loan losses.

It’s not as if the Obama administration isn’t aware of the damage that an avalanche of FHA foreclosures could do to the economy. Testifying this past February before the Senate Committee on Banking, Housing and Urban Affairs, HUD Secretary Shaun Donovan addressed the substantial risks facing FHA’s Mutual Mortgage Insurance Fund and laid out a strategy for meeting the two percent capital reserve requirement by 2015. While admitting that claims had grown in recent years, he emphasized that they were due to mortgages originated prior to 2009.  Through a combination of tightened risk controls, increased premiums and expanded use of loss mitigation, his department has turned around FHA. Yet he called for upfront and annual premiums that would hike total annual receipts by $1 billion.

But this sum might not prove enough. And beyond this consideration is another one: FHA foreclosure mitigation needs an overhaul. Based on its track record, the Obama administration might not realize how daunting this task is. In 2009, the White House instituted two large-scale loan workout programs, Home Affordable Modification Program (HAMP) and Home Affordable Refinancing Program (HARP). Each, particularly HAMP, has had at best limited success. Don’t look now but a HUD foreclosure prevention program focused solely on FHA mortgages, Preforeclosure Sale Program (PFS), also has had its shortcomings. A report issued by HUD’s Office of Inspector General last month concluded that PFS, to an alarming degree, is benefiting scam artists.

PFS, launched nearly 20 years ago after a demonstration phase, allows borrowers in default on FHA loans to sell their home and use the proceeds to satisfy mortgage debt, even if the proceeds are less than the debt itself. In other words, this is a program designed to generate short sales. It allows homeowners with limited equity and high debt, given a lender’s willingness to participate, to avoid further responsibility for debt without having to go through foreclosure.

The “preforeclosure” program works as follows: A homeowner-occupant at least 31 days late on a mortgage payment and who seeks to avoid foreclosure can request from HUD an enrollment form. That person must demonstrate financial hardship. If approved for participation, he must list the property with an unrelated and licensed real estate broker. With a few exceptions, the homeowner has four months to successfully market the property. For the first 30 days of that period, the short sale lender may approve only those offers that will result in net sale proceeds of at least 88 percent of the “as is”-appraised Fair Market Value. If not sold, the floor figure becomes 86 percent for the next 30 days. And if still not sold after that, the figure becomes 84 percent for the remainder of the period. HUD pays the original homeowner $1,000 if a sale is closed within 90 days and $750 thereafter. In addition, the department pays up to 1 percent of the buyer’s closing costs so long as the new mortgage is also FHA-insured. And HUD also pays, up to a point, seller costs and a 6 percent broker’s commission.

On the surface, this sounds like a sensible way for FHA to avoid mass payouts for insurance claims, and ultimately, to avert a taxpayer rescue. Yet the Inspector General’s report, based on a sample of claims paid during September 1, 2010-August 31, 2011, indicates that more than a few people are using the program to line their pockets. Of the 80 sampled claims, the IG found that 61 in some way did not meet criteria for participation. Extrapolating this to all enrollees, the report estimated that HUD had paid $1.06 billion in claims on 11,693 preforeclosure sales during the audit period. The audit, while noting this sum did not represent outright losses, asserted FHA notwithstanding was losing serious money:

While this amount of claims did not comply with HUD requirements, it does not represent a direct loss amount to the FHA insurance fund. The ultimate final cost to the FHA insurance fund would likely be less than this amount because it is reasonable to assume that at least some of these loans could have been processed differently and would have instead gone to foreclosure and become conveyance claims. However, it is also reasonable to assume that at least some of these loans would have resulted in no claim or reduced claims due to alternative loss mitigation procedures.

This wasn’t the first time the HUD Inspector General’s office uncovered unscrupulous use of the program. In September 2005, an IG report concluded: “Investors abused HUD’s preforeclosure sale program and obtained properties below fair market value contrary to HUD requirements. This resulted in excessive claims…” In addition, the audit identified frequent overpayments for insurance claims because HUD “does not have adequate controls within its claim payment system to identify and prevent payments of foreclosure claims that do not meet HUD’s minimum requirements.”

Privatization of FHA’s functions conceivably would minimize not only program abuse, but also the possibility of insolvency. Then-HUD Secretary Henry Cisneros back in 1995, in fact, floated a proposal to transform FHA into a government-owned corporation not unlike Amtrak or the U.S. Postal Service. Yet even this half-measure proved politically unpalatable. A full measure would be a far tougher sell. And it’s little wonder. A privatized FHA would have to behave as would its private mortgage insurer competitors. Rather than intrude upon the PMIs’ turf, FHA would become a part of it. But such a move would necessitate banks turning down higher proportions of risky applicants. And that is something that would be meet with enormous opposition from lawmakers and industry people alike. Homeownership in the eyes of many is still a moral right. And the Obama administration isn’t about to challenge that view.

FHA is only part of a much bigger picture. Virtually all mortgage originations in this country now carry a government guarantee. By far the largest guarantors are secondary mortgage lenders Fannie Mae and Freddie Mac, each of which were placed under emergency Treasury Department conservatorship by the Bush administration in September 2008; about half of the outstanding loan volume is held or backed by one of these two entities. On top of this are mortgages insured or guaranteed by FHA and other housing agencies, such as those within the Department of Veterans Affairs and the Department of Agriculture. The proportion of loans receiving federal backing is now roughly nine out of ten. For now, the country is safe. But a general economic downturn could be calamitous – and not just for FHA.


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